Legal and tax insights into India’s demonetization

By L Badri Narayanan and Amar Gahlot, Lakshmikumaran & Sridharan

India “demonetized” 500 and 1,000 rupee bank notes as legal tender from 9 November 2016. Overnight, “demonetization” became the new talk of the town – a vivid example of a change in law having a drastic impact on people’s commercial as well as personal lives. Though the ramifications are wide, the step seems logical. This is the third in a series of major steps being taken in India to fight black money.

L Badri Narayanan Partner Lakshmikumaran & Sridharan
L Badri Narayanan
Lakshmikumaran & Sridharan

It started earlier in 2016 with the introduction of an amnesty scheme, the Income Declaration Scheme (IDS). The IDS allowed people to voluntarily report undisclosed incomes and assets to the authorities. The tax rate was high, at 45%, but the scheme ended with a considerable success. Marketing efforts put in by the government, along with legal advantages such as immunity from penalties and prosecution, contributed to its acceptance by the public.

Second was the recent enactment of a tough law on fictitious property (benami) transactions, the Benami Transactions (Prohibition) Amendment Act, 2016. The law covers transactions where the real beneficiary of a property is not the person in whose name the property is purchased. The new law empowers authorities to hit hard at such transactions, allowing for attachment and confiscation of such properties.

On the demonetization, a little background first. India has seen demonetization drives earlier as well: in 1946, to counter unaccounted surpluses made by people during the Second World War; and in 1978, with a change in the political regime. So, the latest is the third drive and all three had the same purpose – to counter tax evasion and black money.

Tax laws are a fundamental part of the process of countering black money. With bank notes now invalidated and people coughing them up to banks for exchange and deposit, tax authorities are waiting to react. Curiously, India’s current tax law doesn’t seem to be capable of dealing with this situation. If one deposits the notes with a bank, and declares the same amount in one’s return of income, no higher rate of tax could be attracted. Also, there could be no penalty levied because India levies a penalty when there’s a new, underreported income found by the authorities.

Amar Gahlot Associate Lakshmikumaran & Sridharan
Amar Gahlot
Lakshmikumaran & Sridharan

The only option that the tax authorities had was to amend the law. As on the date of this writing, the government has tabled a bill in the parliament to impose a heavy tax, at 85%, on unexplained deposits which the tax authorities discover. However, there’s a relaxed option as well – reducing the tax amount to 50% if one makes a voluntary disclosure.

A natural question arises on retrospectivity of these amendments. Demonetization has already happened, deposits already done, and the endeavour now is to subject such deposits, made in the past, to a penal tax. This is clearly a retrospective set of amendments being proposed.

It is too early to evaluate India’s demonetization project. The 500 and 1,000 rupee notes amounted to 86% by value of the currency in circulation – their withdrawal is bound to result in issues. However, the government is keen on ensuring minimal disruption and the coming months will provide a clearer picture of the outcome of this policy.

No mainstream country has undertaken demonetization with the purpose of hitting at black money or corruption. Nigeria has demonetized currency in the past to attack corruption, as have Ghana, Myanmar, the erstwhile Soviet Union and Zaire. However, their experiments have not been successful. If India overcomes the odds against, it would certainly be an economic precedent. The country is surely hopeful, and the globe observant, of interesting times which characterize India today.

L Badri Narayanan is a partner and Amar Gahlot is a principal associate at Lakshmikumaran & Sridharan.


B-6/10 Safdarjung Enclave

New Delhi – 110 029


Contact details

Tel: +91 11 2619 2243 / +91 11 4129 9900

Fax: +91 11 2619 7578 / +91 11 4129 9899